State Laws Put Installment Loan Borrowers at Risk

[Pages:42]A report from

Oct 2018

State Laws Put Installment Loan Borrowers at Risk

How outdated policies discourage safer lending

Contents

1 Overview

4 How installment lending works

Terms and conditions6 Cost6 Duration9 Security10

10 Comparisons with payday and auto title loans

11 Harmful features of installment loans

Stated APRs tend to underestimate what borrowers will pay11 State regulations on insurance and other ancillary products significantly affect borrower costs14

17 Where credit insurance is allowed, state laws often provide strong incentives for lenders to sell it

Interest income17 Noninterest income18 Reduced debt collection costs and losses18 Credit insurance is frequently included in loan contracts by default19 Low loss ratios indicate low value to borrowers20

23 Upfront fees, front-loaded interest charges harm consumers who refinance or repay early

Lenders charge maximum allowable fees23 By allowing front-loaded fees, states encourage refinancing24 Lender-driven refinancing is widespread25

27 Policy recommendations

28 Conclusion

29 Appendix A: Methodology

Installment loan locations29 Focus groups29 Installment lending contract analysis29

32 Endnotes

The Pew Charitable Trusts

Susan K. Urahn, executive vice president and chief program officer Travis Plunkett, senior director, family economic security portfolio

Team members

Nick Bourke, director, consumer finance Alex Horowitz, senior officer, consumer finance

External reviewers

The report benefited from the insights and expertise of Kathleen Keest, a consumer finance law expert, former Iowa assistant attorney general, and former official with the Federal Deposit Insurance Corp.; Adam Rust, director of research, Reinvestment Partners; and Katherine Samolyk, an economist and former official with the FDIC and the Consumer Financial Protection Bureau. Although they have reviewed the report, neither they nor their organizations necessarily endorse its findings or conclusions.

Acknowledgments

Pew would like to provide a special acknowledgment of the primary role that former consumer finance senior associate Olga Karpekina had in the preparation of this report. The project team thanks Steven Abbott, Jennifer V. Doctors, Carol Hutchinson, Gabriel Kravitz, Walter Lake, Benny Martinez, Bernard Ohanian, Tara Roche, Andrew Scott, Rachel Siegel, Liz Visser, and Mark Wolff for providing valuable feedback on the report; and Dan Benderly, Molly Mathews, and J'Nay Penn for design and production support. Many thanks to our former and current colleagues who made this work possible.

Cover photo: Getty Images

Contact: Benny Martinez, communications officer Email: bmartinez@ Project website: small-loans

The Pew Charitable Trusts is driven by the power of knowledge to solve today's most challenging problems. Pew applies a rigorous, analytical approach to improve public policy, inform the public, and invigorate civic life.

Overview

When Americans borrow money, most use credit cards, loans from banks or credit unions, or financing from retailers or manufacturers. Those with low credit scores sometimes borrow from payday or auto title lenders, which have been the subject of significant research and regulatory scrutiny in recent years. However, another segment of the nonbank consumer credit market--installment loans--is less well-known but has significant national reach. Approximately 14,000 individually licensed stores in 44 states offer these loans, and the largest lender has a wider geographic presence than any bank and has at least one branch within 25 miles of 87 percent of the U.S. population. Each year, approximately 10 million borrowers take out loans ranging from $100 to more than $10,000 from these lenders, often called consumer finance companies, and pay more than $10 billion in finance charges.

Installment lenders provide access to credit for borrowers with subprime credit scores, most of whom have low to moderate incomes and some traditional banking or credit experience, but might not qualify for conventional loans or credit cards. Like payday lenders, consumer finance companies operate under state laws that typically regulate loan sizes, interest rates, finance charges, loan terms, and any additional fees. But installment lenders do not require access to borrowers' checking accounts as a condition of credit or repayment of the full amount after two weeks, and their prices are not as high. Instead, although statutory rates and other rules vary by state, these loans are generally repayable in four to 60 substantially equal monthly installments that average approximately $120 and are issued at retail branches.

Systematic research on this market is scant, despite its size and reach. To help fill this gap and shed light on market practices, The Pew Charitable Trusts analyzed 296 loan contracts from 14 of the largest installment lenders, examined state regulatory data and publicly available disclosures and filings from lenders, and reviewed the existing research. In addition, Pew conducted four focus groups with borrowers to better understand their experiences in the installment loan marketplace.

Pew's analysis found that although these lenders' prices are lower than those charged by payday lenders and the monthly payments are usually affordable, major weaknesses in state laws lead to practices that obscure the true cost of borrowing and put customers at financial risk. Among the key findings:

?? Monthly payments are usually affordable, with approximately 85 percent of loans having installments that consume 5 percent or less of borrowers' monthly income. Previous research shows that monthly payments of this size that are amortized--that is, the amount owed is reduced--fit into typical borrowers' budgets and create a pathway out of debt.

?? Prices are far lower than those for payday and auto title loans. For example, borrowing $500 for several months from a consumer finance company typically is three to four times less expensive than using credit from payday, auto title, or similar lenders.

?? Installment lending can enable both lenders and borrowers to benefit. If borrowers repay as scheduled, they can get out of debt within a manageable period and at a reasonable cost, and lenders can earn a profit. This differs dramatically from the payday and auto title loan markets, in which lender profitability hinges on unaffordable payments that drive frequent reborrowing. However, to realize this potential, states would need to address substantial weaknesses in laws that lead to problems in installment loan markets.

?? State laws allow two harmful practices in the installment lending market: the sale of ancillary products, particularly credit insurance but also some club memberships (see Key Terms below), and the charging of origination or acquisition fees. Some costs, such as nonrefundable origination fees, are paid every time consumers refinance loans, raising the cost of credit for customers who repay early or refinance.

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?? The "all-in" APR--the annual percentage rate a borrower actually pays after all costs are calculated--is often higher than the stated APR that appears in the loan contract (see Key Terms below). The average all-in APR is 90 percent for loans of less than $1,500 and 40 percent for loans at or above that amount, but the average stated APRs for such loans are 70 percent and 29 percent, respectively. This difference is driven by the sale of credit insurance and the financing of premiums; the lower, stated APR is the one required under the Truth in Lending Act (TILA) and excludes the cost of those ancillary products. The discrepancy makes it hard for consumers to evaluate the true cost of borrowing, compare prices, and stimulate price competition.

?? Credit insurance increases the cost of borrowing by more than a third while providing minimal consumer benefit. Customers finance credit insurance premiums because the full amount is charged upfront rather than monthly, as with most other insurance. Purchasing insurance and financing the premiums adds significant costs to the loans, but customers pay far more than they benefit from the coverage, as indicated by credit insurers' extremely low loss ratios--the share of premium dollars paid out as benefits. These ratios are considerably lower than those in other insurance markets and in some cases are less than the minimum required by state regulators.

?? Frequent refinancing is widespread. Only about 1 in 5 loans are issued to new borrowers, compared with about 4 in 5 that are made to existing and former customers. Each year, about 2 in 3 loans are consecutively refinanced, which prolongs indebtedness and substantially increases the cost of borrowing, especially when origination or other upfront fees are reapplied.

Based on these findings, Pew recommends that lenders, legislators, and regulators improve outcomes for consumers who use installment loans by:

?? Spreading costs evenly over the life of the loan. Origination or acquisition fees should be nominal, proportional to the amount financed, and pro rata refundable to minimize lenders' incentives to refinance loans--and to avoid harm to borrowers.

?? Requiring credit insurance to function like other standard insurance policies, with typical loss ratios and monthly premiums rather than premiums that are charged upfront and financed.

?? Mandating that the sale of ancillary products be separate from the issuance of credit. Credit insurance and products unrelated to the loan should be offered only after a loan transaction is completed and the borrower has either received the proceeds or been notified that the loan has been approved.

?? Setting or continuing to set transparent maximum allowable costs that are fair for borrowers and viable for lenders. If policymakers want small installment loans to be available and safe for consumers, they should allow finance charges that are high enough to enable efficient lenders to operate profitably and prohibit ancillary products rather than setting lower rates and then permitting lenders to sell ancillary products to boost their bottom lines. Existing research is mixed on the overall impact of small credit on consumer well-being, so policymakers may--as those in some states already have--effectively ban small credit by setting low rate limits and forbidding fees and ancillary products.

This report describes the installment lending market, estimating its size and providing an overview of typical loans, particularly elements that work well, especially compared with other subprime credit products. The analysis then turns to examining the two main problems with state laws that result in consumer harm: allowing upfront fees and the sale of low-value credit insurance. It concludes with recommendations to resolve these issues while maintaining access to affordable credit.

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Key Terms All-in APR: The full annualized loan cost, including charges for ancillary products such as credit insurance and club memberships expressed as a percentage of the loan proceeds. This measure is also known as a military APR because it is the rate used in the Military Lending Act.1 Amount financed: The sum of loan proceeds plus the cost of ancillary products. Interest is calculated on the amount financed. Ancillary products: Insurance policies or noninsurance products such as club memberships sold in conjunction with installment loans. Club membership: A product installment lenders sell to borrowers, usually in the form of enrollment in an auto club that provides services, such as roadside assistance or reimbursement for such assistance. The cost of membership is charged in full upfront and financed with the loan proceeds, with customers paying interest to borrow the amount of the dues. Consumer finance company: A nonbank provider of installment loans, also called an installment lender. These companies operate through networks of brick-and-mortar branch locations. Cost: The total amount in dollars that a consumer pays for a given loan, including fees, interest, and the cost of ancillary products. Credit insurance: Insurance sold in conjunction with a loan, which ensures that the lender will receive payments in the event the borrower becomes unable to make them. Installment lenders act as brokers, either including credit insurance in loan contracts or offering it to borrowers. The premiums are charged in full at the outset of the loan and financed with the loan proceeds. Customers pay interest to borrow the amount due for premiums, and the cost of credit insurance counts toward the all-in APR but not the stated APR. Credit insurance loss ratio: The share of premium dollars paid out as benefits that is used as a standard measure of value in the insurance industry. The higher the ratio, the greater the share of premium dollars paid out as benefits and the better the value for consumers. Finance charges: The sum of interest and fees that must be disclosed in the contract under the Truth in Lending Act (TILA). Interest rate: The proportion of the loan charged, calculated on an annualized basis, excluding any origination or transaction fees or the cost of any ancillary products. Large/small loan: For the purposes of this analysis, an installment loan with proceeds of $1,500 or more is considered large and one with proceeds of less than $1,500 is small.

Continued on next page

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Loan proceeds: The amount of cash disbursed to a borrower at the time the loan is issued. Origination (or acquisition) fee: A nonrefundable charge that is either a flat dollar amount or a share of the loan proceeds, is assessed at the time the loan is issued, and is added to the amount the borrower owes. Stated APR: The annualized finance charges expressed as a percentage of the amount financed. This rate has to be disclosed in the contract under the TILA. The stated APR includes certain fees, such as origination, that the interest rate does not; both exclude costs for ancillary products. Truth in Lending Act: A 1968 law requiring uniform disclosure of certain terms of credit, including an APR that reflects interest and certain fees, so consumers can compare loan costs.

How installment lending works

Consumer finance companies offer installment loans in 44 states to borrowers who usually have low credit scores.2 Although allowable finance charges vary significantly across these states,3 prices for these loans are generally higher than banks or credit unions charge customers with higher credit scores. Installment loans range from about $100 to more than $10,000, are repayable in four to 60 monthly installments, and can either be secured--meaning the borrower provides collateral, such as an automobile title or personal property--or unsecured.4 The market is split into lenders who primarily issue small loans, under $1,500, and those that mostly offer large loans.5 Approximately 14,000 consumer finance stores operate nationally, about half of which are owned by the 20 largest national lenders.6 The nation's largest consumer finance company operates more than 1,800 branches in 44 states.7 These national lenders offer small loans in 18 states,8 while large loans are available across all 44 states that allow installment lending. In general, Southern states tend to allow higher prices and have more stores per capita. (See Figure 1 and Appendix A.) An estimated 10 million people spend more than $10 billion annually for these loans.9 These figures do not include installment loans issued by payday or auto title lenders, which are multipayment loans issued at much higher prices than the traditional installment loans described in this report.10

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